The Standard Model of Human Behaviour in Economics - Essay Example

?Table of Contents Table of Contents Introduction 2 Outline of the standard model of individual economic behaviour 2 Assumptions 3 Economic Rationality 3 People have known Preferences 3 People Make Decisions Based on Full Information 4 Strengths 4 Weaknesses 4 Application of the standard model of individual economic behaviour 5 Case1: Monkeys have ‘Irrational’ Aversions to Risk Just Like Humans 5 Case 2: Money Illusion 5 Case 3: Altruism, the Joy of Giving 5 Conclusion 6 References 7 The Standard Model of Human Behaviour in Economics Introduction Economics is a broad area of study as it involves the study of human behaviour that entail the distribution of scarce resources. Different events may be described as economic phenomena that also touch on other areas of study. Like any other social science, economics entails the development of new theories that are aimed at formulating theories to help people get a better understanding of the world they live in (Cartwright, 2011:67). The main goal of these economic theories is to describe and give explanation to relations between economic phenomena. In order to achieve this, the theories are based on a number of assumptions (Baddeley, 2013:56). This explains why the concept of behavioural economics is important as it gives more explanatory power to the economic theory by giving it realistic psychological basis (Wilkinson and Klaes, 2012:1). This goes ahead to prove that behavioural economics seeks to augment the standard model of analysis, not to replace it. The standard model discussed in this paper is used to critique and understand behavioural economics. Outline of the standard model of individual economic behaviour The standard model in economic behaviour is also commonly referred to as the neo- classical model. It is a well established model in the subject of consumer choice and consumer welfare. The standard framework in behavioural economics is basically a decision making model that is normative and descriptive in nature. Additionally, it associates the concept of self interest with maximising utility. This is owing to the fact that the model accurately defines how people behave and gives advice on how they should behave to attain specific goals and objectives. Assumptions Economic Rationality This assumption is based on the fact that acts rational so as to maximise utility. Economic actors face complex situations and a rational decision model describes how most people would act in such situations (Kahneman, 2011:86). The simple model of economic rationality is only applicable to uncertain decisions hence the outcomes are unambiguously related to the actions (Wilkinson and Klaes, 2012:5). This is the most important assumption in the model in fact, the model is referred to as the economic model of rationality. Rationality is a broad term that refers to the everyday reasoning. This interpretation is too complex in the economics context. To explain this assumption further, consumers derive satisfaction or benefits from a particular activity. This is what is commonly referred to as utility in the field of economics. The standard model explains the benefits associated with consuming a good based on monetary value and other benefits including satisfaction. People have known Preferences This explains why the concept of consumer preferences was introduced the simple model of economic rationality is only applicable to uncertain decisions hence the outcomes are unambiguously related to the actions (Wilkinson and Klaes, 2012:6). In this context, individuals are assumed to weigh between different preferences and choose one that gives the preferred outcome (Thaler and Sunstein, 2008:379). There are two assumptions concerning the nature of consumer preferences. First, there is completeness that states that consumers consider an ordering across all the alternatives. Secondly, individuals are assumed to make rational choices. People Make Decisions Based on Full Information The standard model assumes that individuals are able to perfectly evaluate their own preferences based of full information. Individuals can take into account what can is likely to happen in future while making their decisions their decisions. Strengths The standard model matches up to actual consumer behaviour. Mathematical models can be derived from the assumptions of consumer behaviour (Frederick, 202:379). This gives an accurate definition of the issues affecting decision-making (Wilkinson and Klaes, 2012:10). Weaknesses The simple model of economic rationality is only applicable to uncertain decisions hence the outcomes are unambiguously related to the actions (Wilkinson and Klaes, 2012:6). The standard model is enhanced by the two assumptions of Bayesian probability estimation and expected utility maximisation. However, further assumptions should be made to adapt the model’s decision making by extending the period into the future This explains why the concept of consumer preferences was introduced the simple model of economic rationality is only applicable to uncertain decisions hence the outcomes are unambiguously related to the actions (Wilkinson and Klaes, 2012:6). In summary, the model is not satisfactorily general for all decision making. This is owing to the restrictive nature of the assumptions. In some cases, the model is either incomplete or silent on some issues hence it cannot be used to make future prediction (Wilkinson and Klaes, 2012:12). There are issues in the definition of the concept of rationality as since individuals act rationally and the forecast of the standard model may be wrong. Application of the standard model of individual economic behaviour Case1: Monkeys have ‘Irrational’ Aversions to Risk Just Like Humans Economists assume that men are rational beings however; the economic behaviour of humans is no as rational as perceived. When exchanging goods for money, people respond to price as predicted by economists. However, when human beings are exposed to an outcome that is relatively average, they prefer to avoid the making a loss than taking the opportunity to make a gain. In an experiment done by economics by introducing monkeys to the idea of cash, similar behaviour was observed (Wilkinson and Klaes, 2012:22). It is clear that the term ‘rationality’ is ambiguous and can be used in different concepts. Case 2: Money Illusion This has been a widely discussed topic in economics that shows how different individuals value items in terms of money. According to the model, the nominal representation is most important as it is easier to understand and requires minimal information. Case 3: Altruism, the Joy of Giving In an experiment conducted by economists it is clear that people base some of their decisions based on morality (Wilkinson and Klaes, 2012:27). Conclusion The SDT models is an in important concept in behavioural economics. However, further research should be conducted to clarify on rationality and to improve its applicability in all situations. References Baddeley, M. (2013) Behavioural economics and finance, London, Routledge. Cartwright, E. (2011) Behavioural economics, London, Routledge. Frederick, S., Loewenstein, G. & O’Donoghue, T. (2002) ‘Time discounting and time preference: A critical review,’ Journal of Economic Literature, vol. 40, no. 2, pp. 378–379. Kahneman, D. (2011) Thinking: fast and slow, Harmondsworth, Penguin. Thaler, R. & Sunstein, C. R. (2008) Nudge improving decisions about health, wealth, and happiness, London, Penguin Wilkinson, N. & Klaes, M. (2012) An introduction to behavioural economics, Basingstoke, Palgrave Macmillan. Read More